Mudra Compass

While many individuals familiarize themselves with credit scores when borrowing through loans or credit cards, the concept of credit utilization ratio often goes unnoticed. While the significance of maintaining a good credit score for future borrowing needs may be self-evident, it’s crucial to grasp the impact of the credit utilization ratio on this score. The computation of a credit score takes into account various factors, including an individual’s credit repayment history, credit utilization ratio, credit history duration, credit mix, and more. In this discussion, we will delve into the specifics of the credit utilization ratio.

What is Credit Utilization Ratio?

The credit utilization ratio is a straightforward measure that indicates the extent to which your credit limits are presently in use. From a technical standpoint, it represents the ratio between the outstanding balances on all your loans and credit cards and the overall credit limit—comprising both the allowed credit amount and the amounts already borrowed—across all your loans and cards. For instance, if your credit limit is Rs 5 lakh and you have outstanding balances of Rs 1 lakh and Rs 1.5 lakh on two credit cards, your credit utilization ratio would be 50 percent (Rs 2.5 lakh divided by Rs 5 lakh).

As evident, an increase in spending through credit or loans results in a higher credit utilization ratio. This ratio holds significant importance not only in calculating the credit score but also provides lenders with valuable insights into an individual’s credit behavior. A lower credit utilization ratio is indicative of responsible credit management, positively influencing the credit score. Conversely, a consistently high ratio may suggest heavy reliance on credit and potential financial strain for the individual.

What is Good Credit Utlization Ratio?

Determining what constitutes a good credit utilization ratio can vary among different credit bureaus, each having its own set thresholds for categorizing ratios as good or bad. As a general guideline, it is advisable to maintain the total credit utilization ratio below 30 percent. For instance, if your total credit limit is Rs 50000, keeping your outstanding dues at or below 30 percent of this limit, which is Rs 15000, is considered prudent.

While occasional breaches of the recommended 30 percent ratio may be acceptable, especially for emergencies or non-negotiable expenses, consistently maintaining a high credit utilization ratio is discouraged. It is recommended to strive for a ratio below 25-30 percent most of the time, emphasizing the importance of borrowing only when absolutely necessary.

Calculating your Credit Utilization Ratio (CUR) is a straightforward process. The formula is as follows:

Credit Utilization Ratio (%) = (Total Credit Card Balances/Total Credit Limit) * 100

To illustrate, let’s consider a scenario with three credit cards and their respective limits and balances:

Card A:

Credit Limit: Rs 12,000

Current Balance: Rs 3,000

Card B:

Credit Limit: Rs 6,000

Current Balance: Rs 1,500

Card C:

Credit Limit: Rs 18,000

Current Balance: Rs 4,200

Add up all credit limits: 12000 + 6000 + 18000 = Rs. 36000. The total credit balance is Rs. 8700.

Now, applying the formula:

CUR = (8700/36000) * 100 = 24.17%

This result signifies that you are utilizing approximately 24.17% of your available credit.

Ensuring your credit utilization ratio stays in check involves adopting prudent financial habits:

• Spend judiciously, limiting credit card expenses to amounts that can be fully repaid before the next due date. Avoid the mistake of only paying the minimum amount due (MAD) on your cards.

• Despite having a high credit limit on a card, it’s advisable not to consistently max it out.

• Consider requesting a credit limit increase. For instance, if your credit limit is Rs 2 lakh, and you regularly spend Rs 70,000 (resulting in a 35 percent credit utilization, exceeding the recommended 30 percent), first assess your spending habits. Then, inquire with your card issuer about a credit limit enhancement. This can automatically lower your utilization ratio, provided you don’t escalate your spending.

• If you possess multiple credit cards, distribute your purchases across them to maintain low utilization ratios. It’s also acceptable to moderate spending on one card while keeping others unused for a few months.

In addition to these measures, periodically reviewing your credit reports, promptly addressing any inaccuracies, and understanding the various components that contribute to a credit score can further empower individuals in managing their credit health. Regularly monitoring your credit utilization ratio and making informed financial decisions contribute not only to a favorable credit score but also to overall financial well-being. Remember, a holistic approach to credit management goes beyond just the score, encompassing responsible spending, timely repayments, and strategic use of available credit.